SMID Cap Growth – Q2 2018 Commentary

“What we obtain too cheap, we esteem too lightly; it is in dearness only that gives everything value.”

-Thomas Paine

The current trading environment is not boring to say the least.  We have weekly trade war/tariff noise between the United States/China/Europe.  The Federal Reserve seems intent on continuing its tightening path.  The yield curve is flattening and Inflation seems to be popping up in pockets everywhere (with Labor as the exception according to latest employment report).  Despite all this noise, the Russell 2000® Growth Index is up 9 quarters in a row and 17 out of the last 20. Since the end of 2016, the Index is up 34% with Health Care and Information Technology driving 68% of that return (Health Care is up 60% and Information Technology generated a 40% return in that timeframe). Year-to-date, the Health Care and Information Technology sectors are responsible for 89% of the Index return with only 3 sectors outperforming the Index. These sectors have provided consistent leadership in the Early Growth segment of our Asset Lifecycle chart which has been responsible for almost all of the performance in the benchmark.  As we discuss later in the letter, we saw that shift somewhat this quarter (mostly in June) to more traditional/value sectors.  So the question is– have we seen a shift in the market?  At this juncture, we caution there hasn’t been a significant change just momentum dollars chasing returns.  We suggest this based on the numerous data points. For example, below is a P/E ranking of the benchmark (courtesy of Jefferies) that shows the cheapest/lowest P/E names actually have the lowest absolute returns while the highest P/E names continues to generate the highest return.  Our suggestion is even within the names more heavily exposed to the Value index the same phenomenon is occurring.  Valuation does not seem to matter much in our current market.

Source:  FactSet:  FTSE Russell; Jefferies

Performance

The KCM SMID Growth composite was up 5.70% (gross of fees) and 5.53% (net of fees) for the 2nd quarter of 2018 outperforming the Russell 2500™ Growth Index benchmark, up 5.53%. For the quarter, Consumer Discretionary, Materials and Energy were our best performing sectors versus the benchmark. Our largest negative contributors were Industrials, Consumer Staples, and Financials. Our largest overweight was Health Care while Financials and Real Estate were our largest relative underweights.

Strong performance from Russell 2500™ Growth benchmark was driven by an odd couple—Consumer Staples and Energy.  This is a drastic change from the Information Technology and Health Care driven market we have seen for some time.  However, we want to point out money flows quickly shifted towards domestically driven stocks, in our opinion, as investors avoid potential Trade/Tariff land-mines that could be on the horizon.  Another example of this shift in investor behavior would be industries within Information Technology where Software and Internet continued their strong performance (outperformed the index) due to their lack of exposure to trade issues while Semiconductors are significantly exposed to China and were up approximately 2% for the quarter.

Market Outlook

The question we expect to receive is not if, but when, will valuation matter?  Overall, we see this pattern of chasing momentum as particularly difficult to maintain over the long term.  However, the mistake investors can make is to blame momentum for poor or flawed analysis. We understand not all stocks that are rising are doing so based solely on stock momentum. Many in fact are seeing strong fundamentals and investors are merely reacting to the increasing value of the business.  Our view is to tilt the portfolio to these areas but to also maintain our diversification.  We believe this leads to us to a portfolio that can “remain in the game” as we like to call it, when the current market style is against us. A Growth manager who uses valuation as part of the strategy can be pretty lonely when valuation does not seem to matter.  However, our view remains the same—valuation will matter and we maintain our discipline to a balanced Asset Lifecycle approach that in our view produces out performance over an economic cycle.

Sincerely,

John Rackers

Portfolio Manager

 

Please click here for Important Disclosures.

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